A Bad Hand for Bernanke

It’s clear Bernanke’s been dealt a bad hand by the Maestro. But will the gold market fold, raise, or call his bluff…? Our U.K correspondent, Adrian Ash, explores…


Gold’s bull market continues, the noisy setbacks of “hot money” aside.

And as the price keeps on rising, so more and more private investors – looking to put their money to work after 6 years of watching gold outperform stocks and bonds – are joining the search for information and advice on the metal.

But plain facts about gold are just as hard to come by as they are when you’re trading equities or bonds. Falling for the No.1 gold myth, for instance, would have cost you 14 cents in the dollar at today’s prices.

It signaled “sell” back in October last year – and it signaled “sell” again on Tuesday this week, just before gold shot 3.5% higher in one session to reach levels last seen at the quarter-century peaks of May 2006.

Listen to any pundit or metals analyst talking about the price of gold today, and chances are they’ll tell you to watch oil. The price of crude, in fact, has become crucial to the bull market in gold – or so you might think.

“We need oil to break and hold above $60 for gold to rise further,” agree the traders and dealers interviewed by Reuters and Bloomberg each day. Yet by mid-February, oil had failed to hold above $60 per barrel. Gold, on the other hand, stood nearly 10% higher from when oil’s bull market broke down last fall.

What link there is failed to hold firm even during the “commodity bull” that saw hedge funds pile into both oil and gold over the last half-decade or so. Crude oil first turned higher in 1999; gold didn’t get started until 2001. Oil’s major leg up began in 2002 and peaked in mid-2006; gold’s uptrend remains rock-solid today.

More importantly for active gold traders, short-term fluctuations in the gold price have next-to-nothing to do with movements in oil. From 1983 to 2006, the average correlation between their weekly price changes was a mere 0.10. Yes, the connection improves if you look at the three years ending Dec. ’06. It rises to 0.33. But the correlation would be nearer to 1.00 if gold really was “all about oil”.

Compare gold with base metals, and it’s the same story. Even though the correlation of gold with copper, zinc, nickel, aluminum and the rest has been nearly twice as great since the early ’80s as gold’s link with oil, it remains low – below 0.2 on average. What’s more, both the oil and base-metal correlations have varied massively over time. Going from 2006 into ’07 they ranged well above the historic norm. But the correlation still says other factors are more important than oil.

With oil struggling this month as gold moves higher, the long-run correlation of just 0.10 – suggesting a causal link of only 1% according to the principles of statistical analysis – could be making a comeback. Pundits who tell you otherwise, claiming that gold’s all about oil, make the classic mistake of confusing recent events for a law of nature.

It’s not just recent history that creates misinformation in the gold market, however. The major newswires and leading newspapers cite gold as an “inflation hedge” every time they mention the metal.

“Gold’s allure as a hedge against inflation grew after [the] big rise in January consumer prices in the United States,” reported Reuters earlier this week. And it’s easy to see why. For along with bad German wine and the Bay City Rollers, the 1970s cursed the industrialized world with soaring inflation in the cost of living.

Gold’s stellar run up to $850 per ounce came that same decade, ending with the all-time high hit in January 1980. Therefore gold must deliver its strongest returns when the cost of living is shooting higher. Right?

Wrong. “Those that think gold always acts as an inflation hedge are simply mistaken,” as Mike Shedlock of Global Economic Trend Analysis puts it. Just look at the last quarter century.

Consumer prices in the United States, even on the U.S. government’s own data, have doubled since 1982. Gold simply failed to keep pace. In fact, it’s dropped 15% of its purchasing power over that time. At its lowest point, back in 2001, the loss of purchasing power for U.S. investors reached over 75%.

How to square this fact with gold’s huge returns in the ’70s? Perhaps gold only responds to rapid inflation, you might think – the nasty kind we got three decades ago, rather than the “mild” case our money has suffered since then.

But you’d be wrong again. Between 1980 and ’81, U.S. inflation ate 17 cents of the dollar’s purchasing power. The gold price dropped 40% over the same period. And look further back – even to when physical gold stored in government vaults helped support the dollar, just as it did all other major currencies – and you’ll find that gold has always made a poor hedge against rising prices.

In the mid-70s, Professor Roy Jastram of the University of California at Berkeley found that gold had failed to keep pace with the cost of living during seven inflationary periods in Britain. His data ran across more than three centuries!

In the United States, Jastram identified six inflationary periods between 1808 and 1976. They saw the purchasing power of gold fall by more than one fifth on average. Only the final period in Jastram’s study – beginning in 1951 – saw the metal gain value. It continued to gain purchasing power right up to that infamous top of $850. But from then on, it was downhill all the way until spring 2001.

What changed at the start of the 1980s? In two words, Paul Volcker. The key thing to watch isn’t the rate of inflation, not by itself. You need to watch the gap between Fed interest rates and inflation instead.

Real interest rates paid on U.S. dollar accounts averaged just 0.01% between Jan.1970 and Dec.1979. That lack of decent returns made gold attractive on a relative basis. In truth, it only made gold less burdensome.

Gold pays no interest, remember. Indeed, gold costs you to hold it, either by rolling forward futures contracts to maintain a paper position, or through storage and insurance fees on physical bullion. Yes, these costs can be vanishingly small today, thanks to ground-breaking gold investment services such as BullionVault.com for instance. But gold still fails to pay investors any kind of dividend. And the gap between inflation and interest rates has to reach absurd levels to make gold worth holding.

That’s just what happened in the ’70s. It’s what’s happened in the 21st century so far as well. The real rate of interest, the gap between CPI inflation and the Fed’s official interest rate, has averaged just 0.47% since the start of 2000. Real rates during the ’90s stood almost four times as high – and gold fell by one third. Measured against CPI inflation, in fact, its purchasing power dropped by one half.

So what to make of the upturn in real dollar rates starting two years ago? By the end of 2006, U.S. rates adjusted for inflation had shot up to 4%. We last saw that level just before the Federal Reserve first unleashed the flood of liquidity and cheap money still drowning the world’s financial markets today. So the jump in CPI inflation reported this week really did drive that $23 jump in gold prices too – but not because gold offers protection against higher consumer prices. Rather, the Labor Department’s data set a challenge to the Bernanke Fed:

“Will you keep raising interest rates to defend the sollar, pay a decent return to U.S. savers, and crush the gold speculators like Paul Volcker did at the start of the ’80s? Or will you freeze – perhaps even cut real rates – to prop up the housing market, bond prices and the Dow like Alan Greenspan would urge?”

It’s clear that Bernanke’s been dealt a bad hand by the Maestro. But will the gold market now fold, raise, or call his bluff?


Adrian Ash
for The Daily Reckoning
February 27, 2007

Editor’s Note: City correspondent for The Daily Reckoning in London and a regular contributor to MoneyWeek magazine – where a version of this essay first appeared last weekend – Adrian Ash is head of research at BullionVault.com, giving you direct access to investment gold, vaulted in Zurich, on $3 spreads and 0.8% dealing fees.

See here for all the details:


“U.S. mortgage crisis goes into meltdown”, screams a headline in the London Telegraph.

“Panic has begun to sweep the sub-prime mortgage sector in the United States after the bankruptcy of 22 lenders over the past two months, setting off mass liquidation of housing loans packaged as securities.

“The rapid deterioration could not come at a worse time for British bank HSBC, which has set aside $10.5bn (£5.4bn) to cover bad loans in the [United States].

“The cost of insuring against default on these loans has rocketed in recent weeks, from 50 basis points over Libor to 1,200, raising fears that a credit crunch could spread to the rest of the property market.”

The Telegraph went on to quote Peter Schiff, head of Euro Pacific Capital, who said that the mortgage industry is in an “unstoppable meltdown.”

“‘It’s a self-perpetuating spiral: As sub-prime companies tighten lending they create even more defaults,’ he said.”

And from Ohio comes news of an “epidemic” of foreclosures.

So far, 20 companies in the sub-prime lending business have melted down. ResMAE, for example, turned into a blob last week. It filed for bankruptcy less than a year after management cut the ribbon on its new headquarters. The company was making so much money, and expecting to make so much more, that it built a lavish building, fit for a staff twice or thrice as large as the 497 employees it had.

Those were flush times for the lending business. There seemed to be no credit risk not worth taking. But what happened?

Our Law of Stupidity tells us that useful information declines by the square of the distance from the source. As the lending business became more and more “sophisticated”, lenders and borrowers took leave of each other. Finally, they forgot they’d ever met. The Economist explains:

“Banks are traditionally supposed to know a bit about the borrowers on their books. But in many cases, their loans did not stay on their books long enough for them to care. Mortgages were written for a fee, sold to investment banks for a fee, then packaged and floated for another fee. At each link in the chain, the fees mattered more than the quality of the loans, which could always be passed on.”

“For now, though, the Federal Reserve believes the damage can be contained,” reports the Telegraph…so not to worry, dear reader. “‘I don’t think there’ll be a large impact on prime mortgages from the sub-prime market,’ said [Fed] governor Susan Schmidt Bies.”

But, she did admit that there was a “hidden” problem – sellers were pulling their property off the market, and leaving behind a lot of empty houses…and very soft property prices for a very long time.

Meanwhile, Nouriel Roubini (a professor of economics at NYU), thinks all this softness will push the whole nation into recession. As many as 600,000 jobs are being lost…as former real estate agents and ex-nail-bangers look for work. But what are they going to do? Get a job in Detroit? Go down to Nicaragua? Well, actually…but, more on that later.

First, the news…


Chuck Butler, reporting from the EverBank world currency trading desk in St. Louis:

“Did you see/hear our former Fed Chairman Big Al Greenspan talking about the U.S. economy yesterday? Well get this… Big Al says that the U.S. budget deficit is a ‘significant concern’ and that a recession is possible by year-end.”

For the rest of this story, and for more market insights, see today’s issue of The Daily Pfennig


Now, more opinions…

*** A note from Addison:

“There’s no sexiness to it,” an accountant told Matt Crenson, an AP writer following David Walker and the Concord Coalition on their Fiscal Wake Up Tour. She then suggested they hire Oprah to “sell” fiscal responsibility to the American people. Walker doesn’t want to make it sexy… he just wants to wake people up.

Truth be told, these discussions are really, REALLY, boring. Your editors at The Daily Reckoning sat in when the Concord Coalition testified before the Senate Budget committee a few weeks back. We’d sooner have hot-curried chopsticks shoved under our fingernails, than have to endure the procedural protocol of the parliamentary process on discussions of this nature again. And yet, we’ve dragged you into the mix, too.

The folks at the Concord Coalition are trying to sex up the message a little by suggesting 10 questions voters pose to presidential candidates next year. “If they can’t – or won’t – answer these ten questions,” booms David Walker, “they don’t deserve to be the next president of the United States. And frankly, we can’t afford for them to be president!”

We asked you, dear reader, to suggest some questions for the list. Here are just a few suggestions:

“Why is the public being shielded from the truth about the state of the debt in this nation?” writes reader Jeff Jahr.

Patrice Veilleux, writing from New Hampshire, wonders, “How do you propose to increase the average person’s desire and ability to save money?”

Another writes: “How many years should we expect our citizens who labor in small business to fork over 40 – 50% of their revenue stream to federal, state, local and payroll taxes until they say uncle and lay down to become tax revenue consumers?”

And finally, “[Was] Bush correct when he called Social Security a filing cabinet full of worthless paper? And does it mean further that the government has pretty much stolen the money that American workers think is saved and invested for when they retire?”

*** “Do you remember the ancient corpse that was discovered preserved in an Italian glacier a few years ago?” asks our Peak Oil correspondent Byron King. The man had been wounded in a fight, and was inwardly hemorrhaging with an arrowhead in his lungs. He died in a remote, mountainous crevasse where he was promptly buried by snow, frozen solid and covered with ice for several thousand years. His body was discovered by a couple of Austrian mountain climbers.

In a sign of our times, we now have a modern version of that tale. What prompts the comparison is a report from Reuters News Service out of New York, entitled “Mummified body found in front of blaring TV,” posted on February 17, 2007. According to the Reuters report, “Police called to a Long Island man’s house discovered the mummified remains of the resident, dead for more than a year, sitting in front of a blaring television set. The 70-year-old Hampton Bays, New York, resident … appeared to have died of natural causes.”

The body of the decedent was discovered when police were dispatched to his house after receiving reports of a burst water pipe. “You could see his face,” stated morgue assistant Jeff Bacchus. “He still had hair on his head.” The low humidity inside the man’s house had preserved the body to a remarkable degree. No one could explain why the electricity had not been turned off, considering that the dead man had not been heard from since December 2005. Neighbors stated that they were not suspicious of anything because they assumed that the man had moved to a hospital or a long-term care facility.

“It kind of makes sense,” notes Byron, “and there is a metaphysical symmetry to the historical comparison.” Byron explains that “In the ancient past, it took a unique set of purely natural circumstances to preserve the body of the dead man in the Alpine ice. Yet today we live in a world of relatively abundant and cheap energy. In fact, energy is so abundant and cheap that it is possible to die watching TV, and mummify in a dry house for a year, with no one noticing. It was only after natural forces intervened and cold weather froze a pipe, when someone called the police to investigate. And don’t get me started on the process of mental mummification that is facilitated by watching TV. So let’s all continue to enjoy Peak Oil, while it lasts.” Party on, dudes.

*** Oil is over $60. Gold jumped up too. Are these signs of ‘inflation’ of the world’s money supply? No, says the financial press. They are merely signs that investors are worried about Iran, say reporters.

We would look at it in a slightly broader way. There are always potential problems – economic…financial…political…natural. An earthquake could hit California. Or, the Chinese stock market could crash.

Let us stop a minute and consider China’s situation. The Chinese market is in a clear bubble pattern. Its national economy is directed by aging communists. Its banking sector is said to have $1 trillion in bad loans. And its cash flow depends on buying from customers who don’t have any money.

Could China “blow up”? We don’t know…could the next head of the Bank of China be Chinese? Could the next Pope be Catholic?

Typically, when trouble comes, investors try to figure out how they can get through the crisis without losing their lives or their money. But to do this they have to guess what sort of crisis awaits them. Protecting yourself from an earthquake is very different from protecting yourself from a market crash or a war.

Right now, investors with their wits about them have a generous smorgasbord of worries they can sample. A wider war in the Middle East is only one of them. A meltdown in the dollar is another. A crash in the Chinese stock market is still another.

We do not mention natural disasters, because they are probably impossible to foresee…and very difficult to protect yourself from. Should you sell your home in California because the place might be hit by a tremor? We have no opinion. But the threats investors face today come from one source – super-low lending rates that boost speculation and excess consumption. That makes them much easier to predict – and much easier to protect yourself against, too. Bubbly asset inflation is bound to be followed by bubble-popping asset deflation. The best protection is to hold cash…preferably in different currencies, and gold.

*** “You know, nowadays, the economy here in Nicaragua depends on tourism. And people coming down to buy lots and second houses.”

Our friend was explaining what was going on in the property development business in Nicaragua, where we are still vacationing at our beach shack.

“We had a little setback,” he went on, “when Danny Ortega was elected. But I don’t think Ortega is a real threat. He doesn’t control the army or the parliament. And it looks like he doesn’t even control himself. His wife has the real power, according to the rumors.

“No right now, we have more trouble with the North Americans than with the Sandinistas. They get down here…they buy a place…and then they want everything to stop. They don’t want anyone else to build anything.

“What they don’t seem to realize is that if the local people don’t get jobs or can’t start businesses, there’s going to be trouble. You can’t just stop the clock, not with so many poor people. Nicaragua needs more development, not less. The government realizes that. The local people realize it, too.

“But some of the gringos want to preserve things the way they are now. And in a way, I understand. The beaches here are almost deserted…not many houses or people, which is very nice, especially if you come from a city in the United States. But it can’t stay that way. The locals need their jobs and the visitors need places to stay and things to do. There’s no stopping development now. All we can do is guide it and direct it, so we don’t regret it later.”

*** A vacation is as tiring as work…maybe more tiring.

Without the unconscious routines of everyday work life, we are forced to think…and improvise. After a while, it becomes a little tedious… even exhausting.

Yesterday, for example, we had to decide whether to take a long walk on the beach before breakfast…or a short walk followed by a swim…decisions, decisions. Then, what to do at midday is always a big question. The sun is too hot for Northern Europeans between 10 AM and 4 PM.

“Just use sunscreen,” says our better half, insouciantly…but we don’t trust it. Only mad dogs, Englishmen, and surfers go out onto the beach at midday, in our opinion…which leaves us six hours to spend somewhere else.

Should we spend it with Caesar, on his history of the Civil War in Rome…or should we study our Spanish? Should we have a beer or a lemonade? Take a nap or chat with the boys? Decisions…decisions…decisions. We’re not used to so much deciding. We can’t handle it. Then, after 4 PM, we have to decide whether to go for a swim in the ocean…or lie on the beach with a book…or try to learn to surf. And when we get off the sand, should we stay in our beach shack for dinner…or go over to the clubhouse restaurant?

All this leisure is making us nervous, restless…exhausted. Not that we are eager for it to come to an end yet. Still, we look forward to a break from it…back at our office.

The Daily Reckoning